UMGC  – Landstuhl y Rota+                                                                                                                                    Economics 203
Fall (ii) 2020                                                                                                                                                           Exercise 7
 
Exercise 7  (25 points; 15 points individual; 10 points class bonus) (If Extra Credit, maximum score = 15)
Please note that you must complete your answers on this sheet.  And that you must turn in your answers to Exercise 7 before the beginning of our Week 8 class.   
 
Note:  If Exercise 7 counts as an extra-credit exercise, you must answer all of the questions in order to be eligible to receive extra-credit points. If Exercise 7 is a make-up exercise, you must answer all of the questions to receive the 10 class bonus points, as per every other exercise.
 
Last Name, First Name:
 
Individual Score:  (-     = +   /15
Class Score:  +  /10
Total Score:   +  /25
 

1. Question #1 Score = (- = + / 3.0

(Dominant Strategy Equilibrium; Week 6)  (3 points; as marked)
Telesource and Belair are two of the largest firms in the wireless carrier market in Mobileland.  Both firms account for more than 80% of the market.  Suppose they decide to collude and set the same price.  Their payoffs from cheating and colluding are given in the matrix below.

• Explain why both firms have an incentive to cheat. (Make sure you explain how we reach the dominant-strategy equilibrium.) (1.5 points) (-

Answer:
 

• Does this help explain why a cartel is unstable? (1.5 points) (-

Answer:
 
Telesource
 
Collude                                                                    Cheat

 
 
Collude                    Belair earns $24 million                                         Belair earns $4 million
Telesource earns $24 million                                 Telesource earns $30 million
Belair
 
                                Cheat                       Belair earns $30 million                                         Belair earns $20 million
Telesource earns $4 million                                   Telesource earns $20 million

2. Question #2 Score = (-  = +  /3.0

 
(a)           Coase Theorem (Week 7) (1.5 points) (.375 points per segment) (-
For each of the cases below, identify which of them are more consistent with the assumptions of the Coase Theorem (see Week 7 slides) that would produce a privately negotiated solution to a (negative) externality problem.  What assumptions?  Well-defined property rights and low transaction costs.  You must identify which assumptions are violated or met to receive credit for each case.
 

• My neighbor would like me to remove a shrub in my front yard that is an eyesore to his family, not to mention its effect on the property value of his home. (-

Answer:
 

• The entire neighborhood is annoyed that I park an old jalopy on my front lawn. They’re also disgusted that I haven’t painted my house for years so that the paint is cracking, the paneling is rotting, and so on. (-

Answer:
 
 

• A coal-fire electricity plant dumps its leftover hot water into a nearby lake, killing the natural fish population. Thousands of homes line the lake bank. (-

Answer:
 
 

• A coal-fire electricity plant dumps its leftover water into a nearby river, killing the fish population downstream. It turns out that downstream is found a large fishery, which, of course, is most affected by this.  Past this fishery, the water cools so that it’s no longer a problem. (-

Answer:
 
(b)   (Externalities and Coase Theorem) (1.5 point) (.375 per segment)
A local town is under pressure from voters to close a polluting factory.  The head of the homeowners’ organization argues that the pollution is a menace, and if the full external costs of the pollution were calculated, the factory would not be profitable.  The homeowners calculate that the pollution generates an external cost of $3,000,000 per year in medical bills and $1,000,000 per year in suppressed property values, which reflects the difference in home prices with and without pollution.  The factory makes a profit of $5,000,000 per year.
 

• What is the external cost of the pollution? (-

Answer:
 

• If the factory were forced to consider the total social costs of pollution, would it be profitable? (-

Answer:
 

• How much could the town tax the factory before profits become zero? (-

Answer:
 
(iv)           What does the Coase theorem suggest about negotiations between the town and the factory? (-
Answer:

3. Question #3 Score = (- ) = + / 3.0

 
(Externalities; Week 7)  (an interesting application?)  (2 points, .4 points per segment, except where marked)
Cultural influences often produce externalities.  Consider the market for one cultural good:  the romance novel.  In these novels (I’m told!), men are dangerous, yet safe; wealthy, but do not work much; ride high-speed motorcycles without accident; maintain their appearances even though they do not work out, and so on.  (Of course, you could make a similar argument about female models that appear in advertising, if you wish.  So if you’d like to change the example, be my guest.)
 
Consider the market for romance novels depicted in the diagram below, where the market equilibrium is where D (MB private) = S (MC private), as we discussed in class.
 
Price per novel                                  D = MB (private)
S = MC(private)
 
 
 
P*
 
 

 
 
Q*                                        Q (romance novels)
 
(a)           Assume, then, that romance novels impose a marginal external cost (MEC) on men, who (we’re assuming) try to live up to these unrealistic expectations.  Illustrate in the diagram above the effect of this MEC. (-
Answer:
 
(b)           Illustrate in the diagram the deadweight loss that accrues from this externality, before a tax or other solution is imposed. (-
Answer:
 
(c)            If the government decides to compensate for the externality by imposing a tax on romance novels, should the tax be high enough to stop everyone from reading the novels?  Why or why not?  (-
Answer:
 
(d)           Identify on your graph the per-unit tax that would generate the socially optimal solution.  (Simply draw in an arrow that points to the correct segment and label it “Pigovian per-unit tax.” (-
Answer:
 
(e)           As long as the government spends the money efficiently, does it matter what the government spends the money from the “romance novel tax” on? In other words, can the government simply use the money to pay for roads and schools? Or must it spend the money to counter the harmful social effects of romance novels? (-
Answer:
 
(f)            Would you favor such a tax?  Why or why not?  (-
Answer:
 

4. Question #4 Score = (- ) = + / 3.0

(Private Goods and Club Goods); Week 7 (2 points; .4 points per segment)
Perhaps you’ve seen or heard ads claiming that downloading or copying media is equivalent to stealing.  Let’s think about this.
 

• Is a DVD a club or a private good? Why or why not? (-

 
Answer:
 

• Suppose someone steals a DVD from a store. Regardless of how that person values the DVD, does the movie company lose revenue as a result of the theft?  Why or why not? (-

 
Answer:
 
 

• Suppose someone illegally downloads a movie instead of purchasing it. And that this person places a high value on the movie, i.e., values it in dollars more than the selling price in dollars. Does the movie company lose revenue as a result of the theft?  Why or why not? (-

 
Answer:
 

• Now suppose that someone illegally downloads a movie instead of purchasing it. And that this person places a low value on the movie, i.e., values it in dollars less than the selling price in dollars.  Does the movie company lose revenue as a result of the theft?  Why or why not? (-

 
Answer:
 
 

• So how is illegally downloading media similar to retail theft and how is it not similar? (-

 
Answer:
 
 
 
 
 

5. Question #5 Score = (- ) = + / 3.0

 
(Public goods) (3 points; as marked)
Three university students – Johanna, Evelyn, und Ingrid – share an apartment in Paris.  As it begins to turn colder, they’re considering turning up the thermostat in the apartment by 1, 2, 3, or 4 degrees.  They know that when they raise the heat by one degree, their heating bill rises by €16.   The Table below summarizes the marginal benefits received by each of the roommates from the 1^st, 2^nd, 3^rd, and 4^th additional degree of heat.
 

• What is the marginal social benefit from making it 1, 2, 3, or 4 degrees warmer in the apartment? Answer below. (2 points; 5 per heading) (-

 
Enter answer below each degree heading.
 
1 degree                                  2 degrees                                                3 degrees                                4 degrees
 
 
 

• So by how many degrees should they raise the heat in their apartment: one, two, three, or four degrees?  Why?  (Hint:  keep doing so as long as marginal social benefit  ≥ MC, which is €16.)  (1 point) (-

Answer:
 
 
(For DB 7 illustration, see next page.)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
#6            This question is in conjunction with DB 7.  So in order to receive credit for DB 7, you must also use the diagram below to illustrate the author’s argument.  If you’re not posting for DB 7, however, do not answer this question.)
 
Use the diagram below to show what the primary result of the study.  All you must do here is illustrate the first paragraph of your primary post, nothing more.  No explanation is necessary.
 
 
`
P (incarceration)
 
P*
 
 

 
 
Q*                                                        Q (incarceration)